Infant stages
Equity derivatives, as we know them today, are financial instruments that derive their value from price movements of underlying assets, typically a stock or stock index. They’re popular with traders as a means both to speculate, and to manage risk for their stock portfolio. The asset class usually takes on two key forms: equity options and equity index futures, but other forms such as equity swaps, warrants and single-stock futures also exist.
Today, the equity derivatives landscape is highly competitive, with major European exchanges such as ICE, Eurex, Euronext, CME Group – and new player Cboe Europe Derivatives (CEDX) – consistently battling it out for market share. However, it’s only over the last two decades that this competition has really emerged.
Historically, apart from single stock futures and options, competition among European exchanges in the equity derivatives space has been limited, largely because Europe’s index futures and options markets were predominantly domestic. For example, if investors wanted to trade German equity derivatives, they would do so on the German exchange and if they were looking to trade Italian equity derivatives, they would do so on the Italian exchange, and so on.
Learning to walk
Confinements to national boundaries inevitably limited the scope for competition amongst European exchanges, but with the introduction of the European Monetary Union in the 1990s and the opportunity to trade across borders, the needs of customers and the available opportunities were suddenly slightly different – providing a fertile environment for competition to grow.
When looking at the differences between the European equity derivatives market and that of the US, Ade Cordell, president of Cboe NL, notes: “When compared to its US counterpart, the European options market is significantly smaller, even though both economies are of similar size.
“At least two reasons why this is the case come to mind. First, in order to build a pan-European exposure, established participants had to connect to multiple venues and clearing houses, adhere to different pricing structures, and use different market models. Conforming to this access model can prove to be challenging for new participants looking to access this geography.
“Second, the European options market is dominated by a pre-arranged block trading model, often referred to as a call-around market. Larger transactions are agreed off-exchange and reported on a delayed basis, therefore limiting the ability of exchanges to compete for on-screen liquidity and in turn slowing the growth of the market. This contrasts markedly with what participants are accustomed to in the US, which has a highly liquid, on-screen based equity and index options market.”
Coming of age
The European equity derivatives market place has, however, since begun to shift – with competition continuing to grow. ICE, which describes itself as the home of the UK derivatives market, has FTSE derivatives and the MSCI derivatives as its two largest product suites – of which it boasts over 95% and 73% market share, respectively. Meanwhile, Cboe Derivatives Exchange has the CBOE UK 100, which competes directly with FTSE derivatives. Elsewhere, Eurex provides the Euro STOXX derivatives, which it dominates, among several other listings. This brings into question how the big exchanges can differentiate themselves in this highly competitive market – especially given that exchanges sometimes offer products that are very similar. Breaking into this market is no easy task, especially with established players dominating the landscape. So how exactly do you stand out? One thing all major exchanges agree upon is the need for liquidity when offering equity derivatives.
“Liquidity is key. Exchanges are constantly listing alternative or lookalike products but building liquidity in new products is very difficult. If there is a more established product that is already very liquid, clients will just continue to use that,” says Caterina Caramaschi, global head of equity derivatives at ICE.
“In addition to liquidity, something that is increasingly on the forefront of traders’ minds is margin efficiencies as a result of regulatory changes (UMR) and the recent spike in volatility. For example, we offer the most liquid FTSE 100 futures and options contracts globally, we also offer the most liquid MSCI Index Futures globally, covering both Developed and Emerging Market Index Futures. Our clearing houses hold the largest pool of open interest in FTSE UK Index Futures and options and MSCI Index Futures, making ICE the most margin efficient venue to trade these products.
“In January we went live with IRM2 on ICE Clear US for our MSCI Index Futures. IRM2 is ICE’s new Value-at-Risk (VaR)-based portfolio margining methodology that models the behaviour of a portfolio as a whole rather than measuring risk on an instrument by instrument basis. IRM2 has brought even further risk-appropriate capital efficiencies for clearing members and their customers. And finally, how else can exchanges differentiate themselves in this competitive environment? By listening to your clients. Give clients what they want as opposed to what you ‘think’ they want. We are here to serve our clients by giving them tools to risk manage their portfolios.”
Having a broad offering can also help exchanges differentiate themselves and improve their overall competitiveness. Michael Peters, chief executive of Eurex Frankfurt, notes: “The broader your offering is, the more attractive you will be for the market. However, the total cost of trading is an important element as well. This includes not only the actual trading fees, but also the capital costs incurred through clearing and the costs for providing collateral.
“These capital costs are of course largely determined by your margining system and possible portfolio margining efficiencies. The more diverse your product portfolio is and the more derivatives on individual index components are offered in addition to index derivatives, the higher, of course, the potential for portfolio margining efficiencies that can then be realised by market participants.”
New kid on the block
Differentiating yourself and ensuring you stay afloat in a market that is as competitive as the equity derivatives landscape is a feat on its own. But how easy is it to enter the space when established exchanges such as Ice, Eurex, Euronext and CME Group are already so dominant? Cboe chose to take this task upon itself with the launch of Cboe Europe Derivatives (CEDX) in September last year.
“We believe there is a significant opportunity to bring competition to and grow the European equity derivatives market through a differentiated model and CEDX is looking to achieve this in a number of ways,” says Cordell.
“Firstly, the exchange places a strong emphasis on lit order book trading to encourage more on-screen liquidity for equity and equity index options trading in Europe. We have designed our market from a pan-European point-of-view, enabling market participants to access a modern derivatives market through a single access point, creating meaningful efficiencies in trading and clearing. Through a single connection to CEDX, participants can trade a broad range of European country and regional equity strategies, compared to having to connect to multiple domestic venues and clearers currently.
“Finally, we also have the consistency of product and index construction. CEDX products are based on Cboe Europe indices, which are highly correlated benchmarks powered by Cboe Europe market data. These indices are designed and managed under the same methodology, meaning our derivatives contracts have a uniform set of underlying indices and rules. From a futures and options contract design standpoint, our derivative contracts also encompass the feedback that participants have relayed to us, including right-sized index contracts with appropriately calibrated tick sizes.”
Growing pains
With ongoing competition and exchanges’ need to consistently improve their offerings, the equity derivatives market is set to continue to flourish, giving market participants enhanced products as well as better costs of trading. In a landscape where a lot of ‘look-alike’ products exists, it is interesting to see how exchanges respond to requests to launch new or enhanced products.
“When you launch a new product, ask yourself is there a need for this, will this add to a trader’s risk management toolbox or are we just launching more of the same? As exchanges, we need to look at the over-the-counter (OTC) space and provide more capital efficient alternatives to the OTC market. Of course, this comes with its challenges, as you are taking a highly flexible OTC product and standardising it by bringing it on exchange. This could mean a change in how the product is traded and reported, thus, impacting clients back-office systems and vendors etc, and all this requires resources,” says Caramaschi.
“We are continuously looking at the OTC space and trying to find ways to bring this business on exchange. We started doing this back in 2005, with the launch of Bclear (now ICE Block) and more recently, we have focused on the ESG and climate change products with the launch of the MSCI ESG Leaders and MSCI Climate PAI Futures, as interest in socially responsible investing grows. We continue to work with our clients to improve our existing products and launch new products to complement our FTSE and MSCI derivatives offering.”
Building liquidity does pose challenges to the launch of new products as well, especially given that it can take a while to do so. Cordell agrees that launching new products can prove challenging, however, notes that “[Cboe’s] experience in the market so far confirms [its] belief that firms have capital to deploy in the European options market if on-screen market liquidity can be improved. Speaking more broadly, we think participants have resources and time available to assess new exchanges and contracts, particularly with major implementation projects associated with MiFID II and Brexit now behind them.”
In a slightly different take, Eurex’s Peters says that launching new products is easy, however, he notes that: “The question is to what extent you are able to attract interest and generate liquidity as a market operator. That, in turn, depends on the willingness of liquidity providers to quote prices, which is an effort. Here, of course, we are in competition. Equally important is whether products can attract customer flow by the buy-side. And these customer groups will, of course, look closely at where attractive liquidity already exists and where the market is sufficiently deep to be able to execute trades without market impact. In addition, cost efficiency plays an important role for customers.”
A bright future
Competition within the equity derivatives space is likely to continue in the coming years and the level of competition is something that exchanges seem to view as valuable – even healthy. Whether new entrants will (or can) enter the space is yet to be seen, but given Cboe Europe Derivatives’ attempt, we could see more players enter this buzzing asset class. Market participants have an impact, given the decisions they make on where to trade as well as by deciding whether new product offerings will indeed capture their attention.
“At the end of the day, exchanges are here to serve our clients and provide them with the appropriate risk management tools. Our role is to provide liquid and secure markets, with central counterparty clearing and margin efficiencies,” concludes Caramaschi.